Thursday, November 6, 2008 0 comments ++[ CLICK TO COMMENT ]++

Time for investors to start minding the balance sheet

Perhaps this goes without saying. And perhaps it's a bit late.

I think it's time that investors, especially newbies like ourselves, start paying far greater attention to balance sheets. We may be witnessing a monumental change--one that occurs once in 50 years--where the market shifts its attention from the incoming statement to the balance sheet.

Investors such as Benjamin Graham, Martin Whitman, and Seth Klarman seem to place heavy emphasis on the balance sheet. Others such as Warren Buffett and Bill Miller seem to value the income stream. This is not to say that any of them only look at one or the other; rather, their focus is on different areas of the business (clearly Buffett won't invest in anything without a good balance sheet.)

I'm starting to shift my focus towards the balance sheet. For example, a company like Diagoe (DEO) seems great when it comes to earnings power (normalized P/E of around 12) but its balance sheet is not spectacular (debt to equity ratio of 2). I would have considered this extremely attractive in the past but now simply view it as attractive. I believe that branded consumer companies, which trade at above-market multiples, are going to be very vulnerable.

If I am right in my thinking, the market is not going to reward you for earnings in the future. Buying high P/E stocks (or low P/Es for cyclicals) will be risky. That was the case all along but it is even more important now.

(Having said all that, I think it's ok to ignore the strategy if something extremely attractive pops up or if you are making a tactical bet.)

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